Fourth Quarter 2015 – Quarterly Commentary

A funny thing happened on the way to the Forum Or, What will they talk about at the cocktail parties after a year like this?

In a perfect world – which this clearly isn’t – we would all be clairvoyant and know what the future holds. Then, markets would truly be efficient! On the other hand, as Lee Iacocca the fabled CEO of Chrysler Corporation in the 1980s once said; “Yes, God is kind, for if he showed you what was going to happen tomorrow, you’d shoot yourself today”. Let’s just conclude that: without hope, there’s…no hope!

2015 proved to be a problematic year on many fronts with one, one-off saving grace for Canadian investors*. It seems that the markets ceased climbing the proverbial “wall of worry” and took a breather. Quantitative Easing (QE) ceased and the Federal Reserve Board (the FED) in Washington became less “accommodating” as the market mavens like to call it. In fact, the FED was so pleased with US economic growth that it even raised policy lending rates – for the first time in a decade! – by a quarter of a percentage point (from zero to .25%) in December. So, that’s good news right? Actually if the FED is correct it is good news for the economy, albeit maybe less so for the capital markets near term. How so, why so?

If the FED is raising rates, it’s a reflection of the US economy gaining strength which is good news. However, the equity market had already discounted this news and slumped modestly when the speculation of a rate rise became reality. The fixed income markets on the other hand, had already been slumping (yields backing up and bond prices declining) in anticipation of this move by the FED. A stronger economy is not good news for the bond markets as it is thought to herald a general rise in inflationary pressures. For equities, it has mixed effect. Initially, it means that there is more “competition” from risk-free assets (cash) than there was. It also means that funds are flowing from the capital markets into the broad economy. On a flow-of-funds basis this means less buying pressure for equities in the near term. But, it also means that with the economy on the upswing, corporate profits (although already high) are likely sustainable and may improve and that’s good news for equities. So, so far, so mixed on this basis.

The sixty-four trillion dollar question is: IS the FED correct in its call?

*revealed at the conclusion of this report

This seems to be a Dickensian “A Tale of Two Worlds” (with apologies to Charles Dickens). The US seems indeed to be doing all right, albeit not exactly spurting along given the degree of fiscal and monetary adrenaline it’s received over these past six years. That said, US unemployment is hovering around 5% and consumer balance sheets are greatly improved over 2009. Even the US Federal deficit is now below 3% of GDP once again. But the rest of the world seems to be much less healthy economically speaking. Let’s revisit our global trek of December 2014 and see what’s happening around the world as we closed out 2015.

Heading east from New York, we’ll fly to London where things look fairly good as the UK has a) got a stable majority government just re-elected in May of this year and b) with Europe’s leading growth rate in around the 3+% mark. In fact, the real cloud on the British horizon pro-tem is the issue of a possible “Brexit” from the EU if the promised referendum is held this year. It is generally held that the UK leaving the EU in the event of a “No” vote would be bad for both entities. Only time will tell how this vote will unfold and the pollsters have got a very poor track record as far as UK politics is concerned so, for now, it is a toss-up if they are to be believed. Crossing over to the continent, the mood is less upbeat for three reasons: a) Growth continues to be sub-par to say the least. Overall numbers point to something like 1 to 2% continent-wide. Of the big economies, France, Italy and Spain are in a funk. Germany, here-to-fore the growth leader is slowing – why? b) Germany’s biggest export destination is China and China is slowing down more rapidly than anybody thought as recently as three months ago. When one’s trading partners are not doing well, it’s a problem for you, and c) The refugee/immigration crisis is unsettling in many places and for many reasons. While this is not technically an “economic” issue, it can have a dampening effect on investors’ and investment confidence such as the Paris terror attacks showed.

From Paris to Riyadh

The Middle-East remains, well, the Middle-East. Crashing oil prices are playing havoc with national budgets and regional politics to say nothing of the fact that “OPEC” – four letters that used to strike terror into the hearts of oil importing nations – is but a shell of its former self. It seems the “every-man-for-himself” attitude of those who export oil, continues unabated. With oil now hovering in the mid-thirties (in US dollars) this is becoming a serious problem for some inside the club and more than a few outside the club. As far as the Middle-East is concerned, all this is being further complicated by the “civil war” in Syria and the struggle against Islamic State. The lifting of sanctions against Iran will mean another million plus barrels a day of excess oil coming to the global market – not what exporters need right now.

In fact, looking beyond OPEC and flying north to Moscow, we can see the spreading impact of the oil price decline. The rouble has crashed to new lows and the Russian economy is sliding deeper into recession. Inflation is on the rise and Moscow’s tax revenues (from the oil and gas industry) are collapsing. It’s a time-tested theory that if one is having troubles domestically, one needs to take the peoples’ minds off the domestic issues by… creating foreign issues to divert their attention. Voila! Russian intervention in Syria.

If we move from snowy, cold Moscow to sunnier and warmer climes way down in Africa, the situation in Lagos, the capital of Nigeria (Africa’s biggest oil exporter and largest economy) is no better. The good news was a free and fair election in 2015 after which there was a peaceful transition of power from a widely considered corrupt government to a less corrupt one. The problem is that with oil revenues drying up, the new government will have difficulty maintaining existing social programmes and infrastructure let alone improving upon it even if they stem the tide of corruption in the country. Further south, if we wing it to Pretoria, capital of South Africa, their problem isn’t oil but gold with the mining industry in the doldrums and significant economic and political problems mounting. And South Africa is Africa’s second largest economy. The general collapse of other commodity prices has also had a deleterious impact in other parts of the continent. In other words not much good news here for now. Let’s head further east shall we?

Flying to New Delhi India, we have a dose of optimism and good news. Its economy will likely have grown by 7.4% in 2015 and is expected to grow at a 7.6% rate in 2016. This might increase if the many reform bills currently wending their way through India’s parliament are passed in the first part of 2016. Even as things stand, India’s industrial production was up just short of 10% year-over-year to the fourth quarter. India is a long way behind China in the development sweepstakes and faces different challenges than China did but, growing it is and at rates that China used to grow at which, happily, makes sense. India will remain a bright spot in 2016 for global growth.

Now, we fly from Delhi to Beijing where the pilot will have to use navigation equipment to land our plane because of heavy smog. 2015 has been a troubling year for China but still (absolutely) very positive for overall growth. It is expected that Chinese growth will come in at around 7.0% (plus or, minus) for 2015 and decelerate to 6.5% in 2016. These may not be the 10% plus numbers of the first decade of this century, but are still a) very respectable and b) because of the size of the Chinese economy, huge in absolute terms. The “troubling” issue has been the Shanghai stock market which boomed exuberantly (to borrow a word from former FED chairman Alan Greenspan) and then crashed. This latter move has rattled other world markets but, it is widely believed that there is much less of a connection between Chinese shares and the real economy than say between the S&P 500 and the US economy. Still, while clearly there are significant differences between the two, the psychological impact of the crash in Chinese shares does nothing to help confidence at home or, abroad. Further, it might portend a disturbing parallel to the US stock market crash of 1929 after a decade long boom that was dubbed the “roaring twenties”. As the famous Mark Twain phrase goes; “History does not repeat itself. But, it rhymes”.

And now we fly to Tokyo’s Haneda airport where we see that Shinzo Abe’s THIRD attempt to reflate the stagnant Japanese economy is under way. We might say: “Can’t blame a man for trying” but really, the bigger risk could be: “Three strikes and you’re out!” With Japan being the world’s third largest economy we can only hope that this time he succeeds but there are dreadful headwinds, the biggest being an aging (and imploding) population coupled with no net immigration. To this we might add that with global growth slowing – especially in those countries to which Japan exports, it’s heavy sledding for an economy which is already entering yet another bout of deflation. Try, try, try again Mr. Abe. If, in July of 2016, Prime Minister Abe’s Liberal Democratic Party loses control of the Upper House of parliament, this will throw a wrench into the on-going reform process there and could lead to calls for his replacement as PM. If, for any reason, China falls into a “hard landing” it will be virtually impossible for Japan to make any headway at all given its increased level of dependence on the Chinese economic miracle of the last twenty years.

Let’s now prep ourselves for the (very) long flight from Tokyo to Brazil. Landing in Rio, we find much to be chagrinned about. The preparations for the Summer Olympics later in 2016 are not only behind schedule but way over budget. In and of itself this is not, per se, an unusual turn of events – most such sports spectacles suffer such fates from the Montreal Olympics (which as it turned out, did present the world with a “man’s first baby”) to Socchi, considered the biggest sports bust of all time at a rumoured $50 billion! But for Brazil, this is the tip of the iceberg. The really big (multi-billion dollar) scandal lies within the state owned oil company Petrobras which is so pervasive, it threatens to bring down the administration of President Dilma Roussef and divert lawmakers attention away from the real crisis which is an economy in collapse from the massive downturn in commodity prices which carried Brazil’s economy (and many others) for a decade as China contracted to buy everything Brazil could ship it and became Brazil’s biggest trading partner. Now, Chinese demand has evaporated, prices have collapsed and Brazil is in deep financial and economic trouble. This is compounded by serious governmental mismanagement under the current President and Congress as well as several serious constitutional shortcomings which desperately need to be addressed but, under the current circumstances, like a “third rail” are most unlikely to be so. Better news emanates from Argentina to the south where a new government was elected last Fall and the consumer confidence index soared to the highest level in eight years. The flies in the ointment there are that in September, Argentinian industrial production contracted and in October, Argentinian exports fell by double digits reflecting in part, weak pricing and demand, for its commodity exports.

So, let’s return to Canada shall we? Hmmmmm…where to start??? Let’s get the bad news out of the way and go straight to Calgary. To be perfectly blunt, Alberta is a disaster for reasons that do not need going into but, to sum it up in two words: oil and gas. In Newfoundland, they have the same problems and in Saskatchewan, we add potash to the mix of things the world does not place much value in at the present. It’s the knock-on effects of this that are both “good” and “bad” depending on where you are. From Ottawa’s point-of-view, there will be a potentially serious revenue shortfall which will challenge the new government fiscally when it comes to implementing some of its spending plans while staying within its stated target deficit range. We bet the latter will be sacrificed in the name of “fighting recession”. The further challenge will be a lack of hitherto known “have” provinces from which funds are transferred to the “have not” provinces. The “good” news however is for those eastern provinces which still have some element of manufacturing and exports of the non-commodity variety. The dramatic collapse of the Loonie will give exporters some breathing room and help their competitiveness. Further, the fall in gasoline prices acts like a tax cut for consumers everywhere in the country and so will, on that level, create more disposable income. This additional “disposable” income ought by rights, go towards paying down some of the (over) accumulation of household debt which now stands at a disturbing 165% of Canadians’ disposable income. At its peak in 2007, the same measure in the US was “only” 137% of disposable income and we know what that led to. While there are material differences between the US and Canadian consumers’ debt structures the reality is that, if nothing else, the high level of consumer debt in Canada will act as a drag on consumption and growth in the near term. The loonie’s low value is also good news for tourism across the country and may also support the higher end housing market as luxury homes in Canada appear cheap to foreigners looking to make some safe-haven investments from unsettled areas elsewhere. In that sense and, as long as you’re not planning to take a trip outside Canada this year (unless it’s to Russia or Brazil, i.e. destinations with similarly weak currencies) things may not get too bad, Alberta aside.

There is one caveat to the “good” news about the weak loonie…potential inflation. It’s already shown up in your food bill (and will get worse in 2016) but, watch for it to start showing up in higher prices across the board. Canada imports a great deal of what we consume here at home and the years of benign pricing because of a strong dollar are clearly behind us. Distributors of foreign goods will do their best to protect market share initially by holding the line on price increases but ultimately, will not sacrifice their profit margins indefinitely to this end. Prices will have to rise. This could create a negative environment for bonds and possibly Canadian equities. We will maintain a close watching brief on this.

In all, it looks to be another challenging year and one in which Canadian investors may not get the benefit of a falling dollar to create one-off capital gains in their portfolios. In 2015, with the Canadian dollar declining just under 20% (against the US dollar) Canadian investors with foreign holdings – especially US holdings – enjoyed a windfall. In fact, relative to cash, bonds, Canadian and US equities, this currency gain was the best performing “asset class”! The only way this will repeat in 2016 (all other things being equal) is for the loonie to decline by another 20% which, wait for it, will take it down to: 57 cents US. If that occurs, it will cost you $1.75 Canadian to purchase a US greenback. Ouch! Let’s hope there are better ways to generate positive returns in 2016.